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IF YOUR INVESTMENTS climb in value, hold the champagne—until you figure out whether it’s a onetime gain or a repeatable performance.
Suppose your foreign stocks post gains because the dollar weakens. Or your bonds climb because interest rates fall. Or stocks rise because price-earnings ratios head higher. Or corporate earnings increase because profit margins expand. Or stocks jump because the corporate tax rate or the capital-gains tax rate is cut.
Sound familiar? All of these things have either happened over the long haul or helped drive share prices higher this year. You won’t necessarily give back these gains—and, indeed, the dollar could weaken further, interest rates could drop even more, P/Es might rise yet higher, profit margins could widen further and tax rates might be cut again.
But each of these is a road you can only travel once. For instance, since the early 1980s, the yield on the benchmark 10-year Treasury note has fallen from roughly 16% to 2% and the Standard & Poor’s 500-stock index has climbed from less than eight times earnings to 25 times earnings. Treasury yields can’t fall from 16% to 2% again and the S&P 500’s P/E can’t climb from eight to 25 again—unless we first saw a dramatic market reversal. In other words, these are truly onetime gains.
Moreover, in some of these cases, there are limits to how far these developments can run. Theoretically, the dollar could continuously weaken and P/Es could continuously rise, though neither seems likely. But interest rates won’t spend prolonged periods below 0%, profits margins can’t expand so that all of GDP goes to corporate profits and tax rates can’t be any lower than 0%.
So what would count as a repeatable investment performance? It’s reasonable to expect that bonds will continue to pay interest at their stated yield until they mature. It’s reasonable to expect that total corporate earnings will rise along with economic growth, nudging up share prices over time and allowing companies to pay out more cash to shareholders. And that’s pretty much it.
Follow Jonathan on Twitter @ClementsMoney and on Facebook.
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